We value our health very much. We go for a comprehensive medical check-up regularly. But, do we take care of our financial health in the same way? Do we have blind spots that are built into the way that we naturally think, akin to the blind spots in a car mirror?
Blind spots are follies that we should have known or should have realised or should have thought about, and which seem obvious in hindsight. It may be impossible to eradicate these blind spots, since they are embedded into the system. But, we can endeavour to minimise their influence. Here are a few tips.
Focus on process
The need to focus on process rather than on outcomes is critical in investing. In investing, outcomes are highly unstable because they involve an integral of time. One needs to judge an investment decision based on its quality at the time it was made, rather than judge it by the outcome. Having a financial plan and a process to implement it would enable us to maximise our potential to generate good longterm returns. Focusing on the process and its long-term benefits may not necessarily help you in the short term. There may be the pressure to change your process during sustained periods of under-performance.
Align investments to goals
Before investing, the questions you should ask are: What are these funds invested for?; what is the goal? This may sound simplistic, but the time frame of the goal determines investment allocation. To cite an example, prior to retirement, even if your portfolio is performing well, you may have to move certain part of your portfolio to fixed income funds as it would lend stability for your portfolio and help you meet your retirement needs.
Diversification
Risk means that more things can happen than will happen. We do not expect that our house will burn or car will meet with an accident, but it might. So we insure against the risk of fire or accident. We do not expect the stock in which we invest to decline in price, but it might. So, we do not put all our money into one stock. Diversification should be of the right kind and for the right reason.
A portfolio consisting of different mutual funds investing in the same universe of securities, governed by the same regulation and subject to the same market pressure like purchase, redemptions, etc, will have equivalent risk as that of investing in a single fund. That is a classical example of "1/n strategy" — dividing one's investments evenly across various investment options available. The proportion invested in each investment option depends on the number of choices available.
If there are three choices, say three new funds on offer, the investor will split his investments equally among the three choices. This is naïve diversification. Depending on how the choices are structured, individuals can end up taking too little or excessive risk. For eg, if two income funds are on tap, people can invest/allot a proportionate percentage to income funds.
The power of averaging
Statisticians have discovered that the most reliable predictions of all were achieved by taking the average of the results from a number of different forecasting methods. The power of averaging works well for investment decisions and would enable you to eliminate the outliers. Be it diversification of securities by investing in mutual funds or diversification across time by investing through systematic investment plans, a disciplined approach to investing will help you achieve your goals.
Professional advice
Whenever people think they know more than they do, they are under the influence of an illusion of knowledge. Information does make one knowledgeable but when the information is partial and uninformative, it leads to illusion of knowledge. Overconfidence in your abilities may lead to costly mistakes. Moreover, you may not have the necessary time to focus on your finances. Collaboration with a professional financial planner may help you identify your blind spots.
Financial planning is boring
You should not look for any excitement here. It is dull like watching the paint getting dry. Perfect planning and preparation prevent poor performance. This may not make you superrich but it will enable you to gain more control of your financial fortune and ensure that your money plan grows steadily.
(Jaideep Bhattacharya, Group President & Chief Marketing Officer, UTI AMC)